TCS To Tech Mahindra: JPMorgan Sees Margin Erosion In Medium Term
With seven out of 11 techs up for a wage hike in Q2, upcoming margin decline is likely to be more broad-based, says JPMorgan.
Structural margin erosion for Indian IT companies is a key risk to estimates, JPMorgan said, as it remained ‘underweight’ on the sector.
“Sharp margin misses across scale IT Services vendors in the June quarter were deeper than feared with incremental growth coming at lower margins,” the financial services provider said in an Aug. 23 report. “We expect the margin erosion to persist in the medium term and stay meaningfully below long-term trends due to reversal in employee-employer bargaining power, underwhelming graduate uptake, limited price increases, return in travel/facility costs and high onsite inflation.”
“With seven out of 11 techs up for a wage hike in Q2, upcoming margin decline is likely to be more broad-based.”
Structural margins rather than growth slowdown, it said, should be key sector concern.
JPMorgan downgraded Infosys Ltd., Tech Mahindra Ltd., Mphasis Ltd. and Persistent Systems Ltd. to ‘neutral’ from ‘overweight’ given recent price action.
“Our pecking order is Infosys>Tech Mahindra>TCS>Wipro>HCLT in large caps; Mphasis>L&T Infotech>Mindtree in mid caps; and Persistent>L&T Technology Services>Tata Elxsi in ER&D (engineering, research and development).”
JPMorgan, however, sees “limited incremental margin levers ahead to cope with wage increases, persistent retention costs, sub-contractor and creeping up travel/facility costs and find FY23/24 margin expectations optimistic.”
Shares of all Indian IT companies declined in the morning trade on Tuesday, causing the Nifty IT to lose 1.76%.
Separately, Motilal Oswal Financial Services Ltd. said surging macroeconomic concerns impacting the retail sector could drag demand for Indian IT services companies in the near term.
Increasing macro concerns with a slowdown in GDP growth, rising inflation in the U.S. and Europe—the largest geographies for Indian IT Services—and current geopolitical tensions are leading to near-term uncertainty in the Indian IT services space spend from the retail vertical, the brokerage said in its investor note.
“As Indian IT services source a significant share of revenue from retail, the cuts in IT budgets can affect the demand for IT services companies.”
The brokerage also said major retailers are posting slower top line growth and lower bottom line on the back of inflation, supply-chain disruptions and scarcity of key raw materials.
Exposure of IT Companies to the retail sector. (Source MOFSL, Company)
Price hikes taken to offset higher input costs have failed to come on a par with inflation in raw materials, thus contracting the gross margins for these companies, the note said.
Still, Motilal Oswal remains positive on the IT sector, betting on a sustained long-term demand. The macroeconomic concerns are already factored in the recent correction in IT services space, it said.
“As businesses continue to rely on technology, both for driving incremental revenue and optimising costs, the demand for Indian IT services should remain buoyant, despite an uncertain macro environment.”
Motilal Oswal's Valuations For IT Stocks
Also, migration and digital transformation initiatives will continue to boost demand for Indian IT companies. Improved pricing, increased offshoring, higher fresher hiring, lower attrition and lesser reliance on subcontractor costs will help the software exporters maintain margin, it said.